1.(a)Describe in brief the greatest difficulties faced in capital budgeting in the real world.
(b)Mumias Milling Company purchased a grinder 3 years ago at a cost of Sh.3.5 million. The grinder had a life of 8 years at the time of purchase. It is being depreciated at 15% per year on a declining balance. The company is considering replacing it with a new grinder costing Sh.7 million with an expected useful life of 5 years.
Due to increased efficiency, the profit before depreciation is expected to increase by Sh.400,000 a year. The old and new grinders will now be depreciated at 25% per year on a declining balance for tax purposes.
The salvage value of the new grinder is estimated at Sh.210,000. The market value of the old grinder, today, is Sh.4 million. It is estimated to have a zero salvage value after 5 years.
The company’s tax is 30% and the after tax cost of capital is 12%.
Should the new grinder be bought? Explain. (15 marks)
(Total: 20 marks)
2.(a)Mwomboko Company Ltd currently operates with terms of net 30 days. The company has sales of Sh.12 million and its average collection period is 45 days. To stimulate demand, the company is considering the possibility of offering terms of net 60 days. If it offers these terms sales will increase by 20%. After the change the average collection period is expected to increase to 75 days with no difference in payments habits between old and new customers.
The company has variable costs of Sh.70 for every Sh.100 of sales. The required rate of return on receivables is 20%.
Should the company extend its credit period? (Assume a year has 360 days). (8 marks)
(b)Andreas Company Ltd. currently pays a dividend of Sh.2 per share and this dividend is expected to grow at an annual rate of 15% for the first 3 years then at a rate of 10% for the next 3 years after which it is expected to grow at a rate of 5% thereafter.
(i)What value would you place on the stock if an 18% rate of return were required? (7 marks)
(ii)Would your valuation change if you expected to hold the stock for only 3 years? Explain. (5 marks)
(Total: 20 marks)
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